By Lee Burchell
The Dodd-Frank Act in the US and the European Market Infrastructure Regulation (EMIR) have laid the foundation for mitigating risk in the over-the-counter (OTC) markets. They both require interest rate derivatives, credit derivatives, and equity derivatives to be transacted through a central counter-party clearing house (CCP).
To clear OTC trades, the counterparties must post high-grade collateral to ensure settlement. The $141 trillion in gross notional outstanding OTC trades is characterized as too high risk for CCPs and is therefore ineligible for clearing. It will still trade bilaterally but with new conditions attached.
To fortify the rules for bilateral OTC trading, the International Organization of Securities Commissions (IOSCO) and the Basel Committee on Banking Supervision (BCBS) introduced margining requirements within a global policy framework. On September 1, 2016 these rules were introduced in the U.S., Canada, and Japan. Starting March 1, 2017, these rules will be phased into other jurisdictions including Australia, the European Union (EU), Hong Kong, India, Singapore, and Switzerland.
The new legislation has many wondering where firms can obtain collateral, which is now a valuable asset due to its limited supply.
Other post-crisis requirements, including Basel III and Solvency II, force systemically important financial institutions to hold risk-weighted capital and high-quality liquid assets in order to preserve balance sheet strength. This consumes a lot of the collateral supply.
Traditional sources of collateral are in retreat. Regulatory constraints on re-hypothecation and concentration limits on where collateral is sourced restrict the pool of eligible collateral and exacerbate illiquidity in the collateral markets. These constrictions mean small- to mid-sized fund managers are at risk of being excluded from the collateral market. Basel III makes the regulatory cost of repo desks so high that banks will provide repo desk services only to larger, more strategic clients.
Experts predict a 150% increase in demand for collateral in the run-up to the March deadline for posting variation margin on non-centrally cleared OTCs.
Since it’s now harder to find eligible collateral, managers must have a sound collateral management system and renegotiate credit support annexes (CSAs) to account for the new margining rules under the BCBS-IOSCO provisions. The variation margin protocol by ISDA helps managers seamlessly update their existing CSAs to incorporate the changed margining requirements.
To effectively meet margin calls, firms must have suitable technology and operations and a holistic view of how they manage their collateral. Delegating collateral management to a third party with an in-depth understanding of the market and resources is efficient and cost-effective.
To further examine what the buy-side needs to do to prepare for these changes, read our recently published whitepaper, “Intelligent collateral management: An operational necessity for fund managers.”
Since February 2016, GoMargin the straight-through-margining collateral management service from SS&C – has been helping clients with all their collateral management needs. For more information, please contact firstname.lastname@example.org.